The Brighter Side of Decades of Disappointing Investment Returns

The prospects for investors, be they corporate pensions, sovereign wealth funds, or individuals, appear bleak. John Authers, in Thursday’s FT, musters up the evidence (or at least the opinions) that bonds and stocks are both likely to deliver paltry returns for years to come. Sheelah Kolhatkar, in a cover story (and what a classy cover it is) in the new Bloomberg Businessweek, argues that the great alternative to plain-vanilla equity and debt investing — the hedge fund — is more or less over, too. And London Business School’s Elroy Dimson, Paul Marsh, and Mike Staunton, in a Credit Suisse report cited by Authers that’s a few months old but it is well worth downloading and taking the time to read, make a pretty convincing case that the equity and bond returns that came to be perceived in the U.S. as “normal” in the decades following World War II — and particularly since 1980 — are anything but.

We’re all pretty well aware of the negative consequences of low investment returns, although perhaps not of the specifics. Dimson, Marsh, and Staunton calculate that a 25-year-old entering a defined-contribution retirement savings plan — such as a 401(k) in the U.S. — needs to set aside 16% to 20% of her income (!) if she hopes to retire at age 65 at half salary.

Still, where there are losers, there are winners. “While a low-return world imposes stresses on investors and savers in an over-leveraged world recovering from a deep financial crisis,” Dimson, Marsh, and Staunton write, “it provides essential relief for borrowers.” The biggest borrowers these days are governments, and because governments possess powers that most borrowers don’t, they are often able to cut their borrowing costs at the expense of creditors through a variety of techniques that Harvard economist Carmen Reinhart dubs “financial repression.”

Financial repression doesn’t sound like a good thing, and in some ways it isn’t. But the great global recovery after World War II was accomplished in an environment of artificially low interest rates and capital controls — that is, financial repression. So it doesn’t have to be bad economic news. Sometimes governments actually use the money they borrow wisely.

Shareholders can expect to participate only in the growth of the enterprises they are investing in. An important engine for economic growth is the creation of new enterprises. The investor in today’s enterprises does not own tomorrow’s new enterprises — not without making a separate investment in those new enterprises with new investment capital.

So when U.S. stock market returns outpace economic growth, that money has to come from somewhere. It can be taken out of workers’ paychecks, creditors’ pockets, or government coffers. It can come from overseas, as U.S.-based companies take advantage of faster growth elsewhere. And it can come from the future, as investors bet on faster growth to come.

So here’s the big if. If those low investment returns that everybody’s projecting are low just because the global economy keeps sputtering, that’s not good news for anybody. If, however, they signal a regime change in which the financial sector’s great rise over the past few decades begins to reverse and other sectors — governments and workers mainly, although there are certainly business sectors that have lagged as well — grab a greater share of economic growth, that doesn’t have to be a bad thing at all.

To a certain extent, I’ll admit, this amounts to saying that if times are bad they’ll be bad, and if they’re good they’ll be good. But it’s important to draw the link between two important and seldom-connected discussions: one about the prospects for investment returns, the other about the proper role of finance and capital in the economy. Because if the financial sector shrinks in relative size, and working stiffs gain a greater share of national income — both of which would be healthy developments, I think — the share of economic growth going to investors will have to decline.

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